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Thesis:

I see Two Harbors as a leading hybrid REIT. It is undervalued and is poised for success in the long run, considering its exposure to favorable macroeconomic factors, such as a possible increase in the interest rates and further improvement in the housing market.

Business Overview

Two Harbors Investment Corporation (TWO) is a high-yield real estate investment trust (REIT), primarily dealing with residential mortgage-backed securities and residential mortgage loans. The management strives to provide stable and long-term risk-adjusted returns, mainly through dividends by investing in both agency RMBS, whose principal and interest payments are guaranteed by Ginnie Mae, Fannie Mae or Freddie Mac, and non-agency RMBS. This hybrid structure helps TWO's management decrease the individual correlations in the portfolio, thus minimizing the nonsystematic risk. The company also offers a dividend yield of 11%.

Its main competitors are Annaly Capital Management, Inc. (NLY) and American Capital Agency (AGNC).

Key Developments

In late 2012, TWO announced that it will contribute its portfolio of 3,100 single-family homes to Silver Bay Realty Trust Corporation (SBY), a real estate investment trust that engages in the acquisition, renovation, leasing and management of single-family properties, in exchange for 17.8 Million shares of the company. These shares were subject to a 90-day lockup, which expired in mid-March. They will be distributed in the form of a special dividend on April 24, providing TWO's shareholders of record as of April 2 in ratio of roughly 1 share of Silver Bay per 20 shares of Two Harbors (0.049:1). This is equivalent to $1 of dividend per share, or a one-time yield of 8%, in addition to the 10% dividend yield of the company. Without the drag that Silver Bay put on TWO's balance sheet, we can also see the ROA increase.

Another important corporate event took place on March 14, when the company received Freddie Mac's approval to service mortgages (MSRs). This will further diversify the investment portfolio and, due to the fact that MSRs will increase in value in the case of rising interest rates, will act as a hedge against a drop in book value of the Agency MBS.

Financial Strength

Two Harbors is the largest public hybrid REIT measured by market capitalization. In the beginning of 2012, the company was valued at $1.3B - almost three times cheaper than it is now.

TWO had an amazing quarter and reported a revenue growth of 255% compared to 2011 - considerably beyond the industry's average of 16.4%. This increase in revenue led to higher earnings per share for the most recent quarter, although the earnings have been somewhat volatile in recent quarters. For 2013, The Street has high expectations and I believe Two Harbors is able to meet them.

Although the stock has been in an uptrend for a very long time, the company looks undervalued, trading at 10.4x earnings, versus the industry average of 37. The price to sales and price to book ratios are also lower than the industry's averages.

Undoubtedly, Two Harbors' margins are an impressive aspect of its valuation. For example, the gross margin is 85%, versus 50% of its competitors and the operating margin is 54%, which is significantly higher than the average 44%.

The company announced yesterday it will release financial results Q1 2013 after the market close on May 7.

Catalysts

Ben Bernanke implied in December 2012 that the Fed's QE program might decelerate sooner than it was initially expected. In fact, as we see more and more signs of healing economy, we can also expect the Fed to cut back on massive bond-buying programs. This will release the strong downward pressure on interest rates and will cause them to increase, leading to higher spreads for the mREITs. Moreover, MSRs can be a very attractive investment in this case, because their value will go up along with the rates. Fortunately, Two Harbors recently increased its exposure to the MSRs and will be able to benefit.

Two of the signs that suggest improving economy are decrease in unemployment and picking up housing market. Along will come higher prices of residential properties and more sales. I expect this to lead to increase in book value, especially in the non-Agency RMBS area and because of TWO's good exposure to these investments, TWO's shareholders should benefit significantly.

The Stock

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The stock appreciated nearly 25% in 2012. It is also up 7.77% since January 2, 2013, despite the recent pullback in the price. The stock reached a resistance level at $13 a few times in late March, and has been falling since then. It is now near a support level of $11.60-$11.65 and is consolidating around it. The 50- and 20-day moving averages have almost crossed, which will put the stock in a short-term bearish trend. Although I see this event as a positive aspect for potential investors, considering opening a position, I would suggest you wait until there is a clear short-term bullish trend.

Source: Cashing In On Macroeconomic Trends: Two Harbors Investment Corp.